How Markets Dance

Measuring relationships between markets and other factors is what statisticians refer to as correlation. Positively correlated markets tend to move in the same direction, while negatively correlated ones tend to move in the opposite direction. You needn't be a math whiz to understand this concept. Just take a look at a long-term chart: Sometimes markets seem to be moving to the same beat, while other times they appear to be moving to different music altogether.

While a floor trader at the Chicago Board of Trade some years ago, I would spend a good part of each morning trying to understand how bonds were trading compared with stock index futures. There were periods lasting weeks or more, for example, when they'd move in lockstep. Stock index futures would rally, and bonds would follow in almost perfect synchronicity. Conversely, sometimes they'd move in opposite directions, with a rally in stock index futures being accompanied by a drop in the bond market. The most confusing times were when they seemed totally unrelated, with each market seemingly oblivious of the other.

In the markets, the only constant is change. Correlations aren't static still-life paintings — they're animated stories. And because market patterns are dynamic, traders must be constantly observing what's going on. When stocks rally, I'm looking at what other markets come along for the ride. When gold is dropping, what's the dollar doing? What about bonds?

With the help of some statistically minded colleagues, I've generated two sets of correlation tables in an attempt to understand just how the markets are dancing these days. For the longer time period — what I would consider my "control" group — I examined monthly returns of four main asset classes over the period from September 1988 through May 2004. We analyzed equities (S&P 500), bonds (10-year Treasury), the dollar index and gold.

Of course, we might hypothesize in the long-term, but we trade in the here and now. So to understand the current market environment better, and to see how correlations might be changing, I looked at the same data over a much shorter timeframe: 15-minute intervals over the period from April 1 to June 8 of this year.

Data might not lie, but they don't always speak the plain truth, either. Although analyzing market correlation doesn't tell you what to buy or when to sell, it does help traders develop a comprehensive idea of how the markets are working together. The better I understand exactly what's going on, the more likely I'll be in a position to actually make a buck.

For example, gold is often touted as an effective diversification for equity portfolios. And as longtime readers of this column know, this was certainly the case through much of 2001 and 2002, when stocks sank and gold soared. But in recent weeks, for whatever reason, the inverse relationship has become much less pronounced. The correlation between the S&P 500 and gold over the long-term study was -0.198%. Recently, that's narrowed to only -0.022%. The upshot: Gold and stocks have shown a greater willingness to move together than they have in the past. For me, that makes buying gold as a hedge against falling stocks a sucker's bet.

Gold might not be a great way to duck falling stocks, but to hedge against a falling dollar, the yellow metal still can't be beat. Historically, gold and the dollar have exhibited a negative correlation of -0.347%, meaning that gold and the dollar tend to move in opposite directions. The more recent data show that the inverse relationship has become even more solidified, with the negative correlation now at -0477%. From a portfolio manager's perspective, this means gold isn't trading as an inflation play, but as a U.S. dollar hedge. If you believe the dollar will fall, gold continues to be among the most appealing longs.

Yet the dollar hasn't dropped recently. In fact, it has rallied, which makes the dollar/equity market correlation worth examining. Historically, they've shown a positive correlation of 0.131%, with a strong dollar usually being accompanied by a strong stock market. In recent weeks, however, that relationship has weakened, recently exhibiting a barely positive correlation of just 0.069%. So while stocks and the dollar still show a tendency to move together, the relationship is much less pronounced and, indeed, almost now statistically insignificant. This shift in correlation fortifies my belief that cash remains a smart hedge against equities, as falling stocks seem increasingly likely to be accompanied by a rally in the dollar.